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Reselling Vs. Prototype Deliverable?

We are building 25 - 30 prototypes for a customer marketing campaign or promotion. They are not sellable to the public. They are not UL certified or registered as a product, so does it make sense to have sales tax? Anyone run into this before?We've been asked to express this in tax terms and not many people seem to have an answer.

Do we add sales tax to something that is not being resold, but used inside a corporate entity? How should this be posted to our books?

What brought this up is that our supplier asked for a reseller number.

6 Replies

Prototypes are a hairy area, tax-wise. If you want a bulletproof answer to this, it might be worth consulting the state's Department of Revenue (or whatever the California equivalent is); it was surprisingly easy to get in touch with the DOR in Washington, but even they don't have a clear answer to this.

The general line is this: Sales tax isn't necessary if the delivery of the prototypes is considered part of "work for hire." So, if the prototypes are developed and delivered inside a services contract, it's treated as a transfer of paid work and IP rather than as a sale. In this case, you pay standard excise/B&O taxes on your income from the services contract (and any materials expenses you bill to the client), but no sales tax is charged on the prototype hardware.

(The flip side of this is that you can't request a sales-tax exemption on any materials you purchase to build your prototypes, as those discounts apply to wholesalers where sales tax will be collected on the items down the line. I've seen people run afoul of this and try to get away with paying no sales tax on either end.)

Are you being paid for design services, or for the prototypes? That'll be the key question to answer.

Alison,
You can get away with a lot if you don't get a sales tax audit.
If you sell design services and your contract includes deliverables and they are not separately priced you run the risk that somebody will consider the whole contract taxable as the hardware deliverable represents the sale of a product and what you think as service is just the value add to the product delivered under the contract. So $1M in service and $10 of prototype becomes the sale of a $1,000,010 piece of hardware. Even if the customer is not in California you run the risk that the CA Board of Equalization may consider that the sale took place in California if you handed it to the customer in California.
As all of this is a bad thing I am always careful to price out prototypes separately if they need to be mentioned in the contract at all. And if you want the delivery to be in the customers state be sure that they get shipped out of state. Usually I avoid mentioning the prototype deliverable in the contract, but if I do I will sell the proto at the BOM cost. So then the customer (or me) need only pay sales tax on BOM value of the prototype. There are a variety of accounting and revenue recognition issues (like when the proto is not delivered at end, but at some intermediate milestone and what that means on a % completion basis), but haven't had too many complaints about keeping it simple.
1) make the proto a gift and not a contract sales contract deliverable
2) if it is a contract sales item, keep the price at a level to match the parts costs and not make things more complicated than you have to.
Yes, sales tax is on the destination location. A very messy thing because you probably don't want to open up an account with some foreign state. They will annoy you forever even if you never sell another thing in that state.
This are a variety of entertaining issues if you are exporting the proto outside the US, but that is a different set of problems.
Joe

Did you invoice client for services plus costs/materials under a services agreement which explicitly stated delivery of prototype?

Generally not taxable as no production of tangible personal property but It's on a state by state basis.

Some useful criteria to frame your approach are the Number Produced, Nature of Prototype and Use of Prototype. Most likely non-taxable when 1) Low number produced, 2) Nature is not fully functioning and to prove physical qualities/attributes and 3) Use is not for testing but to illustrate physical characteristics and properties only.

Reseller certificate requirement is pegged to taxable status. If you're not reselling taxable services and property, you most likely do not need one.

Again, it's a state by state and specific to your case but overall the above framing should help you ask the right questions.

Allison,
I would view this as the end product of design services and cost the work
to date, then apply sales tax to that. In the end, what would you charge if
the client doesn't move forward with the designs? You may charge $0 if they
do move forward, but that is effectively by applying a credit for work
completed to date. That's my suggestion. Hope it helps.
Roger

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